DEALerSHIP MARKET

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DEALerSHIP MARKET

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DEALlEjRSHIP MARKET

Yakov AMIHUD

Tel-Avlv Umversrty, Tel-Avru, Israel

Columbia Umuersrty, New York, NY 10027, USA

Halm MENDELSON

Unrversrty of Rochester, Rochester, NY 14627, USA

market where the stochastic demand and supply are depIcted by prlcedependent Poisson

processes [followmg Garman (1976)] The crux of the analysis IS the dependence of the b&ask

prices on the market-makers stock Inventory posltlon We derive the optlmal pohcy and Its

characterlstlcs and compare It to Garmans The results are shown to be consistent with some

coqectures and observed phenomena, hke the existence of a preferred mventory posItIon and

the downward monotomclty of the bid-ask prices For hnear demand and supply functions we

derlvethe behavior of the bid-ask spread and show that the transactlon-to-transactlon price

behavior 1s mtertemporally dependent However, we prove that It IS lmposslble to make a profit

on this price dependence by tradmg agamst the market-maker Thus, m this sltuatlon, serially

dependent price-changes are consistent with the market etliclency hypothesis

1. Introduction

growing interest The mam issue m question IS the impact of the actlvltles of

a market-maker, acting on his own behalf (SubJect to institutional and ethical

constraints) on the operational characteristics of the market

In a pioneering study, Garman (1976) presented a rigorous stochastic

model of the dealershlp market This dealership market 1s entirely dominated

by a centralized market-maker, who possesses a monopoly on all trading

Being a price-setter, the market-maker quotes bid and ask prices that affect

the stochastic mechanism which generates market sell and buy orders,

respectively Garman introduced a stochastic analogue of the classic supply

*The authors are grateful to Avraham BeJa, Michael C Jensen and the referees, Robert

Wilson and Peter Kubat, for helpful comments and suggesttons

32 Y Amrhud and H Mendelson, Market-making with inventory

tractable He suggested that the collective actlvlty of the market agents can

be characterized as a stochastic flow of market sell and buy orders whose

mean rate per-unit-time 1s price-dependent This gives rise to a market

supply (demand) curve which depicts the expected mstantaneous arrival rates

of mcommg sell (buy) orders as a function of the quoted bid (ask) price

The possible temporal discrepancy between market buy and sell orders,

and the obhgatlon to mamtam contmuous trading, induce the market-maker

to carry stock inventories, either positive (long posltlon) or negative (short

position) Garman studied the lmphcatlons of some inventory-independent

strategies, which are based on the selection of a fixed pair of bid-ask prices,

and showed how they lead either to a sure failure or to a possible failure (see

also m the next section) He suggested that the specialists must pursue a

pohcy of relating their prices to their inventories m order to avoid failure

[Garman (1976, p 267)] This Inventory-dependent pohcy is, m fact, the

main issue of our paper

In this study we derive the optimal prlcmg pohcy of the market-maker m a

Garman-like dealership market, SubJect to constramts on his short and long

stock inventory posltlons The crux of the analysis 1s the dependence of the

quoted bid and ask prices on the market-makers stock We derive the

optimal pohcy and show that its characteristics are consistent with some

conjectures and observed phenomena It 1s proved that the prices are

monotone decreasing functions of the stock at hand, and that the resulting

spread 1s always positive It 1s shown that the optimal pohcy implies the

existence of a preferred inventory posltlon, as was suggested by Smldt

(1971), Barnea and Logue (1975) and Stoll (1978a) We also obtain some

noteworthy relations between Garmans model and ours concernmg the

ObJective function values and pohcy variables

Focusing on the case of linear demand and supply, we derive the explicit

behavior of the bid-ask spread and the expected tradmg volume as functions

of the inventory posltlon Most importantly, we prove that the optimal

pricing pohcy 1s consistent with the efficient market hypothesis m the sense

that it 1s lmposslble to make a profit by speculating m the market (except, of

course, the market-maker, who enjoys a monopohstlc position) Thus, a

transaction-to-transaction price behavior which lacks mtertemporal

independence may well be consistent with the market etliclency hypothesis

Recently, there has been a growmg interest m the posslblhty of

computerlzmg part of the market-makers functions m the securities markets

[e g, BeJa and Hakansson (1979), this idea goes back to Fama (1970)] This

Barnea and Logue (1975) also argued for an Inventory-dependent prwng pohcy Stall

(1978a) dewed the effect of Inventory holdmg costs on the market-makers quoted prices BeJa

and Hakansson (1979) consider the lmphcatlons of some Inventory-dependent tradmg rules for

demand-smoothmg

Y Amlhud and H Mendelson, Market-makmg wtth mventory 33

the market-maker We hope that our study 1s a step towards the feasible

application of this idea

It has been suggested by Bagehot (1971) that the market-maker IS faced

with basically two kinds of traders the hquldlty-motivated transactors, who

do not possess any mformatlon advantages, and insiders which are

transactors with superior mformatlon He suggested that the market-maker

gains from the former and loses to the latter, and the tradeoff between the

two determines his spread It should be noted that our dealership market

(and Garmans) 1s intended to describe the hqmdlty-motivated transactions

It IS worth mentlonmg some other avenues of research pursued in the

study of market-maker impact on the securities markets The role of the

market-maker as a price-setter and stabilizer m the stock market was

presented by Baumol (1965, ch 3) who studied the effect of his monopohstlc

posltlon on market prices and resource allocation In a recent overview of

market mechanisms, BeJa and Hakansson (1977) discussed some alternative

means to facilitate trading m the securltles markets The impact of trading

mechanisms on various characterlstlcs of price behavior m dealership

markets was investigated m a series of studies by Cohen, Maler, Schwartz,

Whitcomb, and Ness and Okuda In particular, they examined the effect of

market thinness on the moments of stock returns m securltles markets which

operate with or without central market-makers [Cohen, Ness, Okuda,

Schwartz and Whltcomb (1976), Cohen, Maler, Ness, Okuda, Schwartz and

Whltcomb (1977)], furnished a theoretical framework for these phenomena

[Cohen, Maler, Schwartz and Whltcomb (1978a)], and suggested pohcy

lmphcatlons [Cohen, Maler, Schwartz and Whltcomb (1977a)] Cohen,

Maler, Schwartz and Whltcomb (1977b) explained the existence of serial

correlation m the securltles markets, even when the generated quotations

have zero own- and cross-serial correlation, by the existence of bid-ask

spread and non-simultaneous transactions in various stocks BeJa and

Goldman (1977) showed how the way in which expectations are formed may

affect the rate of price convergence to the equlhbrlum price BeJa and

Goldman (1978) also showed how the impact of a speclahst may lead to a

serial correlation m security returns although the underlying process 1s a

random walk

In a simulation study, Bela and Hakansson (1979) assessed the

ramlficatlons of various trading rules adopted by a (programmed) speclahst

whose role 1s to smooth the discrete demand function by buying or selling a

sufficient number of shares to clear the market

Another group of studies [e g , Demsetz (1968), West and Tmic (1971),

Tmlc (1972), Benston and Hagerman (1974), Barnea and Logue (1975),

Logue (1975), and Stoll (1978b)] focus on the determinants of the bid-ask

spread charged by the market-maker They suggest that the bid-ask spread 1s

34 Y Amthud and H Mendelson, Iclarke&makmg wath mventory

market-maker inherent m the traded stock (m particular the specific risk due

to insiders trading) the degree of competltlon, the depth of the market, the

price per share and the volume of trading

The notion of a dynamic price-inventory adlustment policy was discussed

by Smldt (1971, 1979), Barnea (1974), Barnea and Logue (1975) and Stoll

(1976) They suggested that the market-maker has a preferred inventory

position and when his realized inventory deviates from It - he will adjust

the level, and possibly the spread, of bid-ask prices to restore that position

Stoll (1976) presented and tested a model of dealer inventory response to

past, current and future price changes and found that speclahsts tend to buy

stocks on price declines and sell stocks on price increases In a later model,

Stoll (1978a) considered an expected utility maxlmlzmg dealer whose quoted

prices are a function of the cost of taking a posltlon which deviates from his

desired position, and derived the lmphcatlon of his inventory pohcy on the

bid-ask spread and on the structure of the dealership market

In what follows, we present the model m section 2, derive the optimal

pohcy and its characteristics m section 3, and solve for the case of linear

demand and supply m section 4 In section 5, we discuss some additional

aspects and possible extensions

2. The model

The market considered m this study is slmllar to the dealership market

introduced by Garman (1976) The mam features of this market concern the

monopohstlc position of the market-maker and the nature of the aggregate

supply and demand functions Followmg Garman (1976, p 263), the

underlying assumptions on the market are

(A) All exchanges are made through a single central market-maker, who

possesses a monopoly on all trading No direct exchanges between

buyers and sellers are permitted

(B) The market-maker 1s a price-setter He sets an ask price, P,, at which

he will fill a buy order for one unit, and a bid price, P,, for a one-unit

sell order

(C) Arrivals of buy and sell orders to the market are characterized by two

independent Poisson processes, with arrival rates D(P,) and S(P,),

respectively The stationary price-dependent rate functions D( ) and

S( ) represent the market demand and supply, with D( ) < 0, S( ) > 0

(D) The ObJectWe of the market-maker is to maximize his expected average

profit per unit-time Profit 1s defined as net cash inflow

Y Amlhud and H Mendelson, Market-makmg wrth mentory 35

market-maker He derived the probablhtles of failure and the necessary

condltlons to avoid a sure failure Then he modified the assumptions to

analyze two cases In the first, the market-maker sets bid and ask prices to

maximize his expected profit per umt time subject to the constraint of no

inventory drift In the second case, Garman assumed zero price-spread and

analyzed the nature of failure and the duration of the process

Our model IS a natural extension of Garmans As he suggested, we allow

the prices set by the market-maker to depend on his stock inventory

posltlon, which leads to a dynamic pricing pohcy of the market-maker For

that purpose we focus on the stochastic process which describes the

development of inventory This process results from the arrival of market

buy and sell orders whose rates are governed by the pricing declslons of the

market-maker The underlying process of market-orders generatlon m our

model 1s identical to that assumed by Garman The arrival processes are

Poisson processes whose rates are price-dependent Yet, since our concern 1s

with the development of inventory, we shall rewrite Garmans assumption

(C) m a form suitable to our purpose

It 1s well known that the Poisson process IS characterized by independent

exponentially distributed mterarrlval times Thus, a given pan of prices, P,

and P,, generates two competmg exponential random variables z, with

mean l/D(P,), and z,, with mean l/S(P,) [see e g Howard (1971, pp 793-

797)] The next arriving order will occur at time mm{z, z,>, being a buy

order d z, c z,,, or a sell order if z, > TV It follows that assumption (C) may

be written m the followmg equivalent form

(C) For a given pair of pnces, P, and P,, the next mcommg order will be a

buy order with probablhty D(P,)/(D(P,)+S(P,)), or a sell order with

probability S(P,)/(D(P,)+S(P,)) The time until the next arriving

order has an exponential dlstrlbutlon with mean l/(D(P,) + S(P,))

to the discrepancy between supply and demand) IS m fact a birth and death

process [see, e g, Howard (1971, pp 797-814)], whose parameters are

controlled by the market-maker Thus we obtam a semi-Markov decision

process [Howard (1971, ch 15)] where the state variable 1s the stock at

hqnd, and the decision made for a given mventory level 1 is a pair of prices,

P,, and P,, which determine the respective demand and supply rates

The stock at hand 1s assumed to be bounded from above by some

constant L and from below by -K, where K and L are integers and -K c L

This assumption reflects the hmltatlons which are usually imposed on the

market-makers ablhty ot take long and short positions These hmltatlons

result from capital requirements or from admmlstratlve rules Note that the

36 Y Arnlhud and H Uendelson. Market-makmg with mventory

problem of possible rum Formally, we assume

(E) The permissible stock inventory levels are {-K, -K + 1, -K +2, . ,

L-2, L- 1, L}

For convenience of exposltlon, we re-number the states as (0,1,2, ., M

- 1, M}, where M= L+K We assume M 2 3. We also adopt the

conventional termmology o&rth and death processes, and let rl, denote the

birth rate m state k, and R the correspondmg death rate. We also define cl0

=A, =0 Since A, = S(P,) 1s a monotone mcreasmg function of PbL, there IS

a one-to-one correspondence between 1, and Pbk Simlarly, pk IS a monotone

decreasing function of Pak, with a one-to-one correspondence Thus, the

transition rates I, and pk (rather than the correspondmg prices) ~111be used

as the decision variables m state k

The market demand and supply ft&l&s give rise to the market-makers

revenue and cost functions, respectively,

and

C(i)=J P,(rz)=I2 s-(n)

Rb) represents the expected sales revenue per unit time corresponding to

demand rate p (which IS, m turn, a function of the pre-determined ask price

Pa) Analogously, C(n) 1s the expected cash outlay per unit time, which

represents the cost of inventory replenishment

We make the followmg regularity assumptions on R( ) and C( )

respectively, are twice contmuously differentiable with

(1) R( ) is strictly concave, I e , R(p)<O,

(ii) C( ) is strictly convex, 1e , C(Iz)>O,

(III) R(O)>C(O), R(oo)cC(co)

Finally, we assume

(G) There are no transaction costs to the market-maker

Note that the existence of a transactlon cost 5 per trade [see Garman (1976,

p. 266)] paid, e g , by the market-maker, will simply shift the supply and

demand functions by a constant, retammg the convexity and concavlty

properties of C( ) and R( ) Thus, there IS no loss of generality m assummg

<=O (Obviously, other costs which are constant per unit time do not affect

the optimal pohcy )

Y Amthud and H Mendelson, Market-makmg wrth Inventory 37

assumptions (A)-(G) Followmg assumption (D), the ObJectWe function IS

[Howard (1971, p 868)]

(1)

k=O

where

& is the earning rate for a transition from state k, I e , the expected cash flow

dlvlded by the mean sojourn time In terms of our model, the expected cash

flow per transition from state k 1s

1k R@k)-C(Ak)

--&- pabk)- - Pb(Ak)=

Ik+pk Ik+pk Ak+pk

(2)

known that the stationary probablhtles 4k (k =O, 1, , M) satisfy the relations

that is, the expected flow from state k to state k+ 1 equals the expected flow

m the opposite direction It follows that

(4)

Let

(5)

be the mean rates of mcommg sell and buy orders Then (3) lmphes

X=ji, (6)

that is, the expected flows In both directions are equal Relations (3) and (4)

are valid only when A,>0 for k=O,l, ,M-1 and pk>O for k=l,2, ,M

38 Y Anuhud and H Mendelson, Market-makmg with menlory

It will be proved m the sequel that under the optimal pohcy, the birth and

death rates are Indeed positive

In this section we first derive the optlmahty condltlons and then study

then lmphcatlons on the behavior of the market-maker By a stralght-

forward dlfferentlatlon of the obJectlve function (1) we obtain the followmg

necessary condltlons for optlmahiy

(7)

J=k+l

pk f ~,CR(~,)--((I,)l--k~kR(~k)=g~,C1)

J=k ]=k

By subtracting the (k + 1)st equatron of (8) from the kth equation of (7)

and using (3) we obtain

that here it relates to each pair of nelghbormg states Note that since

PaOLk+l)>R(~k+~)=C(~k)>Pb(~k), (10)

a purchase of one unit at state k and Its sale at state k+ 1 always yields a

profit z It follows that a loop of transitions starting from any state k,

traversing other states and returning to state k yields a posltlve profit with

probability one Thus, when the market-makers mltlal resources (cash plus

available credit) exceed XL-,-,P,,, the probability of cash failure [Garman

(1976, p 263)] is zero, even m the worst possible case Since the probability

of default by the market-maker 1s zero, mltlal credit (If needed) should be

available

Subtraction of (7) from (8) yields

c(n,)-n,c(n,)+g~,~)=O, (IlO)

c(n,)-n,c(nk)+g~,~)=ROI,)-~kR(CIk), (Ilk)

k=l,2, ,M-1,

ZA sale of a umt at state k+ 1 can always be attributed to a purchase at state k (except for

the mtlal stock)

Y Amrhud and H Mendelson, Market-makmg wrth mventory 39

g@4.4=wMhdwhf) (119

Eqs (11) give the basic relation between A, and Pi, and thus the relation

between the bid and ask prices for each inventory posltlon k It follows that

the optimal (A,,p& are aligned along the curve defined by

[note that @,,O) and (0,~~) are at the intersection of the curve with the

positive semi-axes] Lemma 3 1 proves that the curve (12) depicts a

downward sloping function on the positive quadrant

and

$IcQ)-X(A)]

<o QED (134

The followmg theorem establishes that the optimal bid and ask prices are

monotone decreasing functions of the stock at hand [This result IS consistent

with the dynamic pricing pohcy described by Smldt (1971, 1979), Barnea

(1974) and Barnea and Logue (1975) ]

Theorem 3 2 Let P,, and Pak, respectively, be the optimal bid and ask prices

at state k Then P,,>P,, >P,,> >P,,,_, and P,, >P,,> >PaM

Equtvalently, 1, > A, > I, > >A,-, andpl<p2<p3< <PM

m terms of price behavior follows from the moiotomclty of the demand and

supply functions

We first prove that i, >A, By subtracting eq (1 lo) from (11) and noting

that R(c(~ )/pl > R(pl ). we obtam

40 Y Amthud and H Mendelson, Market-makmg wzth mwntory

follows that p, <pz, and then we obtam by Lemma 3 1 that A, CA, The

proof IS completed by mductlon Q E.D

The following corollary shows that the bid-ask spread IS always posltlve,

as might be expected

p.k=p*o1k)p,o1k+l)~p,(~k)=p,k QED

We now turn to compare our results to a case treated by Garman (1976,

pp 265-266) Consider a market-maker who wishes to prevent a drift m his

expected inventory Thus he sets prices so as to equate the rates of mcommg

buy and sell orders, 1e , p =A, regardless of his inventory posltlon This

market-maker acts like an ordinary monopohst who equates marginal

revenue to marginal cost

It might be argued that the profits of this monopolist, who restricts himself

to p=I, are lower than those of our market-maker who enjoys a greater

flexlbdlty m setting prices Yet, our market-maker has constraints on the

long and short posltlons which he can take, whereas Garmans monopolrst

has no such constraints In fact, the followmg theorem proves that the profit

of Garmans monopolist 1s an upper bound on g&p)

g@,pli)<R(r*)-CO-*) (14)

g&p)= 5 4rCRW-C(&)1

k=O

Jensens Inequality,

where p and X are given by (5) Furthermore, it follows from (6) that ji=X 1s

a subset of the constraints m our problem Now, Garmans problem can be

Y Amahud and H Mendelson, Market-makmg wtth anventory 41

written as

maxh(l,p)=R(p)-C(1)

st j.l=A,

g~,~)<R(jl)-c(X)~h(r*,r*)=R(r*)-C(r*) QED

vamshmg transitian rate That K., the profit-maxlmmng market-maker will

never choose to refrain from makmg buy or sell transactions (except for the

case where he reaches his hmltmg posltlons) This also means that relaxing

his constraints by expanding the allowed short or long posltlons strictly

Increases the market-makers profits

and pn>Ofor k=l,2, ,M

Proof It 1s sufficient to prove that ~1~=0 IS not optimal 3 For that purpose

we apply Howards (1971, pp 983-1005) pohcy improvement procedure to

show that a pohcy with p1 >O 1s an improvement over the pohcy with pL1=0

Let the mltlal pohcy (2,~) be such that pL1=0 and A, = I* (note that smce

state 0 IS transient, the value of I, does not affect g), with relative state

values Us Consider an alternatlve pohcy @,g) where A=A, & = p, for all

J# 1, but & = r*/2>0 Let r1 be the value of the test quantity [Howard

(1971, p 986)] for evaluating the orlgmal pohcy at state 1, and P1 the

correspondmg test quantity for the alternative pohcy Then,

r,=-c(n,)+(n,+o)[l Q-U,],

and

r;=R(r*/2)-C(1,)+(I,+r*/2)

[ :;*,2v1+A

1

1

$2o-u1

1

, 1

hence

r;-r,=R(r*/2)-r*/2 (ul-u())

More generally, the proof ImplIes that addmg one state to a cham strictly Increases the value

of g (m that chain) Hence, the cham resultmg from the optlmal solution must contam all states

42 Y Amrhud and H Mendelson, Market-makmg wzth mventory

Now, (IJ~-u,,) IS found by performing the pohcy evaluation procedure for the

initial policy at state 0,

that IS,

r;-f,>R(r*/2)-R(r*)/2>0 QED

{&},=o under the optimal pohcy It follows from Theorem 3 5 that & > 0 for

all k=O,l, , M, so there 1s a posltlve probablhty of finding the market-

maker m any of the allowed inventory positions In addltlon, other

properties of {&},=o are of interest What IS the shape of this dlstrlbutlon7

Is there a preferred inventory posltlon [Smldt (1971, 1979), Barnea (1974),

Barnea and Logue (1975), Latank et al (1975), Stoll (1976)] If there IS, what

can be said about the preferred rates and pnces.7

Smce ~k+l/4k=~J~k+19 the properties of {&},=, may be obtained by

consldermg the transition rates 2, and /A~+~ The followmg lemma relates Ak

and pk+l to Garmans no-dnft rate r*

(II) If pk+ I > r*, then

C(A,)=R(p,+,)<R(r*)=C(r*),

Lemma 3 6 states that r* IS always located between i, and pk+ 1 This fact

IS Illustrated m fig 1

Y Amrhud and H Mendelson, Market-making wth mventory 43

that

pkSr* for kSJ, pk>r* for k>J (16)

Proof First, 1, > r* smce otherwise we would have A, ~1,s r* 6p1 < pk+ 1

for all k= 1,2, , M - 1 This would have lmphed x<p, m contradlctlon to

6) A slmdar argument leads to py > r* It follows from Lemma 3 6 that

r*

h+l Xk

Expected number of buy (~1 and sell (A) orders

per unit time

Fig 1 The market-makers revenue as a function of the arrival rate of buy orders, R(P), and his

replemshment cost as a function of the arrival rate of sell orders, C(A) r* IS the arrival rate

chosen by Garmans monopohst, maxlmlzmg R(r)- C(r) 2, and pr+ 1 are related by (9) and

thus the Interval [pt+ 1,AJ embraces r*

decreasmg function of k Let

J=max{k)1,_,/p,&l}

(17) imply

4k2$Jk-19 whereas k > J, & < c$_ 1 It follows that 4. <

for <4,-2-C

4J-1 S4,P and $J>4J+1>4J+z> >& Now, (15) and (16) follow

from Lemma 3 6 and from Theorem 3 2 QED

44 Y Amrhud and H Mendelson, Marketqakmg wrth rnventory

produces a preferred Inventory position J, located away from the hmltmg

positions 0 and M The preference for posmon J 1s reflected m both the

ummodahty of the dlstrlbutlon and m the fact that the decline rate of & as k

withdraws from J, IS faster than a geometric decline rate (since 4 J&-l IS

decreasing) Furthermore, when the market-maker finds himself m a posmon

different from J, he will quote prices which will tend to bring him back to

that posmon. That IS, the probablhty that the next transition will be m the

due&on of J will exceed the probablhty of moving towards the extreme

positions This aversion from the extremes follows since being there forces

the market-maker to make transactions at unfavorable condmons

Furthermore, at the preferred inventory posmon J, L and p are

approximately equal An exact equality between I and /1 IS obtained at

(1,&, where the curve (12) intersects with the 45-lme (see fig 2) The actual

(AJ,pJ) IS located m the neighborhood of (A,$), m the followmg sense

Let a = mm (A,, pJ}, and A = max {A,,pJ} Then,

and

(a,A)c(~,+,,C1,+1)C(~,+,,~,+2)C = (O,Phf),

where a51=pS A

Thus, all the intervals between 1, and pLkstraddle the interval between 1,

and p,, which m turn straddles A=pl This gives (A,pi) the mterpretatlon of

being the approximate likely rates of the market-maker If some I, happens

to equal 2, then k = J IS the preferred inventory posmon and A, = I =P = pJ

are the exact modal rates

We finally relate the likely rates (A,$) to (r*, I*), the rates of Garmans

monopolist

Theorem 38 d=p<r*

h(r*)=R(r*)-C(r*), and by (12), h(l)=g It follows from Theorem 3 4 that

h(l)<h(r*), hence 1=p<r* QED

The above relation, together with (15) and (16), are summarized m fig 2

Note that both (n,,pL,) and (A,$) he on the segment slsl Furthermore, the

only (&,p,J contamed m this segment are the modal rates More specifically,

when I,_,/~J>l, we have ;1,_,>r*>p,>p,_, and 2J+l<<J<r*<pJ+1

Y Amrhud and H Uendelson, Market-makmg with mventory 45

Fig 2 The curve [R(p)-pR(p)] - [C(n)-X(i)] =g, along which are ahgned the optunal

arrival rates of the pubhc buy and sell orders br and I,, respectively, with the subscrlpt

denotmg the related Inventory posItIon) The hkely rates sattsfy 1=~ The actually preferred

rates (A,,p,) are both less than or equal to Garmans rates (r*.r*), thus they are contamed m

the segment s,s2

Hence, both modal rates are smaller than the rates of Garmans monopohst,

I e , (A,,pJ) IS mslde s1s2, and for k#J, (A,,p,) hes outslde slsl In the case

where 1,-,/p,= 1, (Ar-l,~,_,) and (A,,p,) comclde with the endpomts s1

and s2, respectively, m this case, both J- 1 and J are the modes of the

dlstrlbutlon {c#J,},=

O

The lmphcation of the above results on the preferred bid and ask prices

charged by the market-maker IS lmmedlate P,, 1 P,(r*) > P,(r*) >PbJ, and

the preferred bid-ask spread IS always greater than the correspondmg

spread set by Garmans monopohst This also implies that the preferred bid-

ask prices straddle the market-clearmg price F at the mtersectlon of the

demand and supply curves P IS the unique price at which the expected rate

of buy orders equals the expected rate of sell orders (p = A), thus clearing the

market on the average Garman (1976, p 266) suggested that P IS the price

set by a benevolent zero-cost market-maker who provides a non-profit

public service by filling all mcommg orders from his inventory The choice of

P thus guarantees no expected drift m the market-makers inventory,

together with zero expected profit [under assumption (G)] However, if there

IS a fixed cost 5 per transaction, then the spread net of transaction cost ~111

46 Y Amthud and H Mendelson, Market-ma&q with muentory

market-makers The ordinary sufficient condltlons for perfect competition in

such a market are that entry 1s costless and free, that [see Fama (1970, p

387)] all available mformatlon 1s costlessly available to all market-makers,

and that they all agree on the lmphcatlon of current mformatlon for the

current demand and supply functions There may be additional costs to the

market-maker, notably the opportunity cost of his resources tied up m the

dealership activity, and the actual cost of transacting As usual, competition

leads to a pricing of the dealers services so as to reflect the costs of

provldmg these services If these costs were zero, competltlon would lead to a

zero spread, and the assumed homogeneity of expectations would lead to P,

=P, =P (since any other price will leave the market uncleared on the

average) The existence of positive costs of provldmg dealership services leads

to a positive spread which straddles P 6 When the cost per transaction 1s a

positive constant r [see dlscusslon followmg assumption (G)], the

competltlve spread will equal 5 > 0

In this section we apply our general results to the special case of linear

demand and supply functions, D(P,) = y -6P,, and S(P,) = c(+/lP, Then,

R(P)=(~/@(YP--P*), and C(~)=(l/B)(~-Ia)

Here, the locus (12) of possible (&,p& IS the ellipse

P21~

+ A2IB

=g 9 (18)

whose axes comclde with the coordinate axes The likely rates are given by

the mtersectlon of the 45~line with the ellipse

1=p=JgB6/0 (19)

(20)

whereas the market-clearing rates, (P,@), at which the demand and supply

5A posltlve spread ~111 exist whenever real resources are tied up m the market-makmg

function

6For a dIscussIon on the determmatlon of the bid-ask spread on the basis of the dealers cost,

see Demsetz (1968), West and Tmlc (1971)

Y Amthud and H Mend&on, Market-makmg with mventory 47

(21)

It follows that Iz~1 ~1 (and p <pm <@) (see also Theorem 3 8) The

correspondmg prices (usmg the respective upper-scripts) satisfy

It IS of interest to investigate whether the bid and ask prices set bv the

market-maker always straddle the market-clearmg price P This happens If

and only if all I,, pk are not greater than A=pc (otherwise, d some I, >L

then P,, >P,, >Ir, if some /_+>@, then both prices are below P) This 1s

equivalent to requlrmg that both A,,, pMsIze =@ (since I, =max,..,,, 1S .MAk

and hzmaXk=O, 1,2, ,Mpk)

In our case, a suffclent condltlon for the market-clearing price P to be

straddled by all the bid-ask prices Pbk,P.& (k=O, 1, ,M) 1s

(22)

defirutlons of R( ) and C( ),

g<R(r*)-C(r*)=(r*)2/6+(r*)2//l, (23)

hence

Thus, when the (absolute values of the) slopes of the demand and supply

curves are not grossly different, P c [P,,, Pak] for all k

We now proceed to mvestlgate the behavior of the bid-ask spread set by

the market-maker According to the dynamic pnce/mventory adJustment

theory suggested by Smldt (1971, 1979), Barnea (1974) and Barnea and

Logue (1975), the spread should be mmlmal when the market-maker IS at his

preferred inventory level, and widens as his long or short posltlon 1s

undesirably high Our model yields a similar behavioral pattern

This phenomenon was attrrbuted to the higher risk of posltlomng See also Latane et al

(1975, pp 73-75), who m addltlon consldered the effect of rtsk on the spread set by dlfferent

speclahsts Benston and Hagerman (1974) and Stoll (1978b) provided a cross-sectlonal emplrxal

study on the effect of the risks Incurred by holdmg Inventory on the bid-ask swead across

shares

48 Y Amrhud and H Mendelson, Market-makmg wzth mventory

given by

(24)

and

dd/dCc= (l/M/~ - I)

The function d(A, cc) 1s thus mnnmrzed at (A,#), and increases as (1,~)

approaches the hmrts (&,,O) and (0,~~) It follows (since pk increases with k)

that the market-maker reduces the bid-ask spread as he approaches the

likely inventory posrtron This result and Theorem 3 2 yield a bid-ask price

pattern which 1s illustrated m fig 3 Observe that this pattern resembles the

one presented by Latani et al (1975, p 74, fig 41)

Next, we study the effect of the market-makers inventory posrtron on the

total volume of transactrons By setting bid and ask prices he determines the

supply and demand rates, 1 and ~1,whose sum grves the expected number of

transactions per unit time Thus, Iz+/J represents the expected volume per

unit time [Equrvalently, (2 +p)- 1s the expected inter-transaction time ]

Using (24) we obtain

(d/d/M + P) = I - /W P/A

[~[__]___I___&__ .__ PO

I

I I

1Ib

A

I

J Inventory

l0V.l

(Profrrrrd poritaon 1

Fig 3 The bid-ask prx.es and the correspondmg spread, A, as a function of the market-makers

Inventory level

Y Amthud and H Mendelson, Market-makmg wtth tnventory 49

As the inventory level approaches one of the short or long hmlts, the volume

decreases as expected

We conclude the dIscussIon of the hnear model by exammmg the

important issue of market efflclency In our dealership market, efficiency (m

the fan game sense) implies that it 1s lmposslble to make economic profits

by trading against the market-maker It 1s well known that a sufficient

condltlon for market efficiency 1s that market prices behave as a random

walk However, the prices m our model do not adhere to this property since

their dlstrlbutlon 1s mean-reverting * Thus, market agents might be tempted

to form a trading rule based on past price behavior, by which they would

profit through buying from the market-maker at low prices and selling back

to him at higher prices However, we shall show that any trading rule which

1s based on momtormg the behavior of the market-maker 1s useless and is

certain to produce a loss More specltically, we shall show that the pricing

pohcy of the market-maker results m all ask prices being greater than all bid

prices To show this, observe that by (23)

The model also gives us the transient price behavior which derives from the transient

behavror of the inventory (recalhng that quoted pruzes are one-to-one related to Inventory)

Startmg from an uutlal state I at time t=O, the probablhty of lindmg the system in state 1 at

time th0 IS given by the (z,j)-entry of the matrix eA where A IS the correspondmg transItion-

rate matrix [see, e g , Howard (1971, ch 12)] The matrix e can be wrltten as the sum of a

matrix whose rows are all ldentlcal to the stationary probablhty vector (&,, c#J~,&, ,&) (row

ldentlty reflects independence of the mltlal state), and M addItIona matrices which reflect

dependence on the mltlal state The latter matrices are multlpbed by coefficients which are

exponentially decaying as a function of t Thus lf we observe the system at state I at some time,

the dependence of the state observed t time-units later on the mltlal state I dlmuushes to zero at

an exponential rate (as t-co) The corresponding relatlonshlp between observed quotations of

bid and ask prices and any mltml quoted prices readily follows Slmdarly, the observed

transaction prices form a tM-state birth and death process with hmitmg probabihtles

P{observed prlce=P,} =& P&+J.~), and P{observed prlce=P,} =I$& AJOlt+&) The

previous remarks regardmg temporal dependence apply as well to this process (with a dllferent

transition-rate matnx)

50 Y Amthud and H Mendelson, n4arket-makmg with inventory

= ,/$, we have

hence,

It has long been noted that the random-walk property of prices IS not a

necessary condltlon for market efficiency m the fair game sense [Fama

(1970)] In fact, emplrlcal studies have shown that serial dependence m price

changes co-exists with market efflclency m the sense that it IS lmposslble to

make profit by use of publicly available mformatlon Our model provides a

theoretical framework which implies a transaction-to-transaction price

dependence, together with market efficiency As can be seen from fig 3, the

systematlc pattern of prices cannot be used to make a profit since all ask

prices he above all bid prices Therefore, any trading rule that attempts to

profit from this price dependence 1s certain to produce a loss the bid-ask

spread will wipe out any prospective profit

The last result implies that market traders can make no profitable use of

mformatlon which 1s also available to the market-maker Even a knowledge

of the market-makers current inventory position and his pricing pohcy

(derived from the demand and supply functions) cannot produce a profitable

trading rule This result agrees with Bagehots (1971, p 13) observation that

the market-maker always gains m his transactlons with liquidity-motivated

transactors Yet, there may be insiders, 1 e , transactors who possess special

mformatlon which IS not available to the market-maker, and can make a

profitable use of it In other words, mslders have a more accurate assessment

of the demand and supply functions than that of the market-maker, and they

may use their superior mformatlon to make profit in excess of their cost

lmphed m the bid-ask spread As Bagehot (1971, p 13) noted, the market-

maker always loses to these insiders, and these losses represent an inventory

Y Amlhud and H Mendelson, Market-makmg wrth rnuentory 51

the hquldlty-motivated transactors and not the insiders demand and supply

A model which ~111 take account of the mslders tradmg m an exphclt

manner is a most important extension This model should also contain a

learning mechamsm by which the market-maker uses market mformatlon to

update his assessment of the demand and supply [see Bagehot (1971, p 14)]

It IS worth relating our ObJectWe function (I e , expected average profit per

unit time) to value maximization, which implies here contmuous

dlscountmg of cash flows at some instantaneous discount rate u This gives

rise to a rate-dependent transaction-to-transaction discount factor, which

represents the present value of obtammg one-dollar at the next transaction

It has long been known [see Jewel (1963, pp 95&957)] that for small

discount rates (which are equivalent to close-to-umty transactlon-to-

transaction discount factors), the dlscounted value crlterlon turns out to be

well approximated by our average profit criterion I1 It should also be noted

that the relevance of dlscountmg to existing dealershlp markets 1s limited

when settlements take place a few days after the transactions, smce then the

actual tlmmg of a transaction 1s of no importance If the underlymg

condltlons m the market are such that dlscountmg 1s of importance, It 1s a

stralghtforward matter to formulate the problem as a discounted dynamlc-

programming problem Then, there 1s no direct analogy to our formulation

of the ObJectWe function (l), and our closed-form results will be replaced by

recursive relations Clearly, such a reformulation ~111be at the expense of the

models tractability

Consldermg the role of mventorles m this paper, note that our market-

makers pohcy depends on his stock inventory positIon, whereas his cash

flows appear only m the objective function The role of the cash position

may be interesting m a combined cash-mventory dependent pohcy, where the

market-maker maxlmlzes his expected utlhty of consumption

It may also be of interest to study the sensltlvlty of the results of our

model to the underlymg assumptions on the order arrival process This can

be done m several ways The order size may be assumed to be a random

variable which represents orders of varying size Furthermore. the

assumption of Poisson arrival may be extended to a more general renewal

process This may raise the necessity for an empirical study of the mterarrlval

time dlstrlbutlon *

loThe need for contmuous dlscountmg results from the fact that the mtertransactton times are

not ldentlcally dlstrlbuted

If, for example, the yearly contmuous discount rate IS 14% (which IS equivalent to 15 Y0 per

annum) and the expected Inter-transactlon time 1s as large as an hour, the relevant discount

factor 1s 0 999984

A step m this dIrectIon IS Garbade and Lleber (1977)

52 Y Amlhud and H Met&son, Mark.&makmg with mwntory

References

Bagehot, Walter, 1971, The only game m town, Fmancnd Analysts Journal, March-Apnl, 12-14

Bamea, Anur, 1974. Performance evaluation of New York stock exchange specmhsts. Journal of

Fmanclal and Quantitative Analysis 9. 511-535

Barnea, Anur and Denms E Logue, 1975, The effect of risk on the market-makers spread,

Rnancml Analysts Journal 31, Nov /Dec. 45-49

Baumol, Wdham J , 1965, The stock market and economic etliclency (Fordham Umverslty Press,

New York)

Ek~a, Avraham and M Barry Goldman, 1977, On the dynanuc behavior of prices m

chsequhbrmm, Mlmeo

BcJ~, Avraham and M Barry Goldman, 1978, Market pricts vs eqmhbnum prices Returns

variance, serial correlation, and the role of the specmhst, Working Paper no 78-51 (New

York University, New York)

&~a, Avraham and Nds H Hakansson, 1977. Some alternative market mechanisms, Workmg

Paper no 104 (New York Umverstty, New York)

Bela, Avraham and Nils H Hakansson, 1979, On the feasiblhty of usmg a mechanical speciahst

m securities trading, Paper presented at the XXIV Meeting of The Institute of Management

Science

Benston, George J and Robert L Hagerman, 1974, Detemunants of bid-&ked spreads m the

over-the-counter market, Journal of Financial Economics 1, 353-364

Cohen, Kalman J, Walter L Ness, Hltoshl Okuda, Robert A Schwartz and David K

WhItcomb, 1976, The determinants of common stock returns volatdrty An mternatlonal

companson, Journal of Fmance 31, 733740

Cohen, Kalman J, Steven F Maler, Walter L Ness, Hitoslu Okuda, Robert A Schwartz and

David K Whitcomb, 1977, The impact of designated market makers on security prices I,

Empwlcal evidence, Journal of Banking and Finance 1, 219-235

Cohen, Kalman J, Steven F Mater, Robert A Schwartz and David K Whitcomb, 1977a, The

Impact of designated market makers on security prices II, Pohcy proposals, Journal of

Banking and Finance 1,236-247

Cohen, Kalman J, Steven F Marer, Robert A Schwartz and David K Whitcomb, 1977b, On

the existence. of serial correlation m an e&lent securltles market Working Paper no 109

(New York University, New York)

Cohen, Kalman J, Steven F Maler, Robert A Schwartz and David K Whitcomb, 1978, The

returns generation process, returns variance and the effect of thinness m securities markets,

Journal of Finance 33, 149-167

Demsetz, Harold, 1968, The cost of transactmg, Quarterly Journal of Economics 82, 3353

Fama, Eugene F, 1970, Eficient capital markets A review of theory and empirical work,

Journal of Finance 25, 383-417

Garbade, Kenneth and ZVI Lleber, 1977, On the independence of transactions m the New York

Stock Exchange, Journal of Banking and Finance 1, 151-172

Garman, Mark B , 1976, Market microstructure, Journal of Fmancial Economics 3, 257-275

Howard, Ronald A, 1971, Dynamic probablhstic systems, Vol II Semi-Markov and declslon

processes (Wiley, New York)

Jewell, Wdham S, 1963, Markov-renewal programmm& II Infinite return models, Example,

Operations Research 1I, 949-971

Latane, Henry A, Donald A Tuttle and Charles P Jones, 1975, Security analysis and portfolio

management (Ronald Press, New York)

Logue, Denms E, 1975, Market-making and the assessment of market efliciency, Journal of

Fmance 30 115123

Smldt, Seymour, 1971, Which road to an efficient stock market Free competltlon or regulated

monopoly, Fmancial Analysts Journal 27, Sept /Ott , 18-20, 64-69

Smldt, Seymour, 1979, Contmuous versus mtermlttent trading on auction markets, Paper

presented at the Western Fmance Assoctatlon

Stall, Hans R , 1976, Dealer Inventory behavior An empirIcal mvestlgatlon of NASDAQ stocks,

Journal of Fmancial and Quantltatlve Analysis, 356380

Y Amrhud and H Mendclson, Market-makmg wtth mwntory 53

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1133-1151

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